A blog about economics, finance, business and corporate governance. My background is in economics, with degrees from Columbia and Johns Hopkins. A career in international development, equity capital markets and as a corporate finance chief and board member lead me to think about events in a different way--hence the blog's name.

Friday, June 29, 2012

Fresh off a recent post on foreclosures, I was doing a final read of the Wall Street Journal when I came on their article about Bank of America's $40 billion mistake in acquiring Countrywide Financial.

Here is an excerpt that speaks to the issue of dealing with delinquent mortgages and eventual foreclosures. It is a mind boggling mental picture: "Countrywide saddled Bank of America with hundreds of thousands of delinquent borrowers, thrust it into the middle of a foreclosure-paperwork scandal and exposed the bank to countless lawsuits from mortgage-bond investors and insurers. The number of people handling poor-performing real-estate loans for Bank of America ballooned from 5,000 at the time of the Countrywide purchase to 50,000. Those people occupy at least 4.5 million square feet of office space around the country, the equivalent of 78 football fields."

What's really appalling is that all those horrible collectors and others occupying that 4.5 million square feet are dealing with real people whose lives are being turned upside down. I understand that many of the borrowers were gaming the system too. But none of this should have happened at this scale because Countrwide's underwriting should have been reined in by regulators, and it should never have been acquired by any kind of rational board of directors.

First question: if Raj Rajaratnam has paid millions in clawed back profits from a relatively puny insider trading scheme and been banned from the securities industry while spending eleven years in prison, why on earth is Angelo Mozillo not in the Federal pen on multiple life sentences? I am among millions of Americans who are asking the same question about Mozillo.

Finally, here's a laughable quote from Ken Lewis the former CEO of Bank of America: "The Merrill Lynch and Countrywide integrations are on track and returning value already." (from Wikipedia) His 2007 compensation was $20 million. Shareholders wanted earnings growth and management rewarded themselves for delivering a chimera instead.

Bank of America is the best performing stock in the Standard and Poor's 500 year-to-date! We talk about kleptocracies in a number of other countries, some of which claim decocratic processes. We need to have a serious look at the virus of a crony capitalism which is thriving in our own markets, untouched by any meaningful reform.

Bill McBride who blogs at Calculated Risk commented on CoreLogic's 63,000 completed foreclosures in May, flat with April and below the year ago level, with a degree of optimism. Like an iceberg, most of the inventory is below the surface, I suspect. Here in lower Westchester County, New York walking around my old neighborhood, there are many homes at various stages of descending into foreclosure. A flagship Mediterranean home in the neighborhood lay vacant for four years after the owner lost it. It was recently purchased by new owners, not investors. Most of the sales here are distressed, and the neighborhood is filled with homes not yet in the formal process. The inefficiency and incompetence of municipal governments further impedes a resolution process.

As I've said many times before, banks never thought that they would be in the business of foreclosing, especially on such a large scale. Banks can barely deliver core checking and savings accounts efficiently, and they certainly are not humane or efficient about foreclosures. The mortgage servicers as a whole are a fly-by-night group and they weren't built for this either.

CoreLogic does note that foreclosure inventories are still rising in states like New York and Connecticut. Believe it.

Thursday, June 28, 2012

Equity shareholders can be a useful voice for all stakeholders in helping corporate managements to allocate capital better. For example, Walgreen's overspending to acquire a stake in Boot's or HP overspending to acquire Autonomy are recent examples. Big acqusitions, either for cash or for debt are not bond-holder friendly. Just read any credit report on a company. Yet, unless there are restrictive covenants attached to their instruments, bond holders can do little about free spending managements.

Equity shareholders can, and do, speak up directly and through analysts in the capital markets. To the extent that they shine a light on big acquisitions or even discourage them, they perform a valuable service for all stakeholders by lowering the risk level for future free cash flows.

Shareholders do not, however, have some divine right over and above other holders of corporate claims. Common equity holders have a residual interest in the company, after all other claims have been satisfied. The earnings can be retained or distributed as dividends, again not through some divinely communicated formula. Bond holders would prefer that no dividends be paid, because there would be more cash to settle their claims; shareholders reasonably have other expectations. The point is that the shareholder claim is a residual one.

We've written about the primacy of hedge funds within the shareholder base of many public corporations. Their holding periods may be days or weeks, and their interests are not generally in the long term interests of the corporation, which is "to be in business forever." (Those are Harvey McKay's words for McKay Envelope.) Short-termism and excessive risk taking have ruined too many public companies to list. In fact, we are still crying about the excessive risks that bank CEOs took during the financial meltdown.

Yet, they took those risks precisely to satisfy shareholders with unsustainable earnings growth, and to feather their own nests through rent capturing compensation. And we want to elevate shareholders by fiat to the top of the stakeholder pyramid?

Nell Minow has been part of creating a large industry around the shareholder primacy mantra. As a long time equity analyst and public company CFO, investors and shareholders were always important to me as customers and stakeholders. Over time, however, I got to see up close and personal how pernicious the influence of certain bad actor shareholders can be to the interests of companies. The other side of the aisle is represented by Lynn Stout of the UCLA Law School who writes on this issue in today's New York Times.

The shareholder primacy industry has just resulted in more mind numbing proxy boilerplate, more checklists for boards, more window dressing around egregious corporate compensation and has opened the door for meaningless, costly and sometimes harmful activism. That this springs from a misreading of corporate law needs to be addressed for the benefit of all stakeholders.

Managements should actively listen to their shareholder concerns by looking them in the eye, not from on their knees in fealty.

The German Finance Minister's remarks before today's summit gave encouragement to Eurocrats who see checks being written and more jobs being created for themselves. I was very surprised to read the headline, until I read this from the Wall Street Journal report itself:

"Mr. Schäuble said Germany could agree to some form of debt mutualization as soon as Berlin is convinced that the path toward establishing centralized European controls over national fiscal policy is irreversible. That (?) could happen before full implementation of treaty changes."

There is very much less here than hit the headlines, in my opinion. I don't believe that Spain, France, or Italy among many others are ready for any form of European control over their national fiscal policies. This statement by Schauble is a clever way of throwing things right back into the court of Hollande and the other Eurocommunards. If you want Germany to agree to some form of debt mutualization--probably not the one you're thinking about--then give up national sovereignty over fiscal policy.

If the Spanish government is too proud to accept a European bailout and too arrogant to accept aid to its banking sector through European regulatory intermediation, how could they accept this kind of scenario?

No, I don't believe that much at all has been conceded by Chancellor Merkel, her own words nothwithstanding. I don't read "concession" into the German Finance Minister's remarks. There is still a long way to go.

Tuesday, June 26, 2012

Back on January 2012, we wrote: "We're still looking for reasons why the consensus 2012 oil prices shouldn't be closer to $80ish than $100+ for 2012." At that time, there were many bearish forecasts for oil, some of which related to fears about closure of the Hormuz Strait. Today, crude closed at about $79.43 on the NYMEX.

The consensus broker forecasts made no sense at that time, and the oil prices were inconsistent with other real economic components of the forecasts. From the intra-year peak to here, I can't piece together what drove us to the peak, as the Hormuz hype was just that. Technical issues with Brent v. WTI can't explain the runup either.

Oil price markets, like stock markets, often drift away from their economic underpinnings.

Monday, June 25, 2012

Just when I thought I understood something about the world of municipal finance, here comes a story from the New York Times about taxpayers being on the hook for promises made on their behalf, without their consent, by municipal bond issuers! Here's an excerpt:

"With many cities now preoccupied with other crushing costs — pension obligations, retiree health care, accumulated unpaid bills — a sudden call to honor a long-forgotten bond guarantee can be a bolt from the blue, precipitating a crisis. The obligations mostly lurk in the dark. State laws requiring voter pre-approval of bonds don’t generally apply to guarantees. Local governments typically don’t include them in their own financial statements or set aside reserves to honor them.

“These are debts that do not show up clearly, no matter how closely you look at the balance sheets,” said Carmen M. Reinhart, an economist at the Peterson Institute for International Economics who has written extensively about government debt. They “come out of the woodwork in bad times.”

In a number of communities, especially in New Jersey, Michigan and Washington State, local officials have recently scrambled to work out fiscal emergencies caused by guarantees and similar promises.." (New York Times)

In order to give the reader a respite from unrelenting municipal malfeasance, I want to make a musical link to the theme of promises. Below is a YouTube video of Eric Clapton playing "Promises." (nice slide guitar playing)

(At the 0:16 mark, you'll see a shot of John McVie and Eric from a session for "John Mayall and The Blues Breakers Featuring Eric Clapton," a great album I have on British Decca vinyl. Fantastic)﻿

We recently wrote about HP and about how the smart value investors at FPA got whipsawed. We noted the awful stock chart, and today the price broke $20 intra-day, a level which seemed to have decent support. John Dvorak in his widely read market column calls for HP to hire a "visionary leader." He describes current CEO Meg Whitman as being "a functionary." I understand where's coming from, but I think his characterization is a bit hard. I also disagree with his statement about vision. The company has had visionaries from Carly Fiorina on through today: hardware visionaries to software visionaries to the present CEO. Enough is enough about visions.

The world of HP external stakeholders definitely need much better communication about where the business is going, why and how fast. All of the non-GAAP to GAAP reconciliations are nice, but they leave all the fundamental questions unanswered and allow no real forward valuation of the company prospects. The limited sample of institutional research I see tells me the analysts don't know where the company is going in terms of cash flows and returns. Autonomy would be the logical place to start. Keeping mum yields no benefits, and any meaningful clarity would go a long way.

They also need focus on improving the portfolio as it is. Commit to standing shoulder to shoulder with their customers. assuring them HP will do whatever it takes to earn their trust, keep their business, and help them to grow their profits with HP technology and services. More vision will yield only more nightmares.

I do agree with John on a substantive point which he clothes in humor. He writes, "The last dumb move was the company’s purchase of Autonomy, a odd U.K. software company that seems to specialize in the creation of screwball corporate cliches using the word “meaning” as the cornerstone. For example, they engage in “meaning-based computing” and “meaning-based governance” and “meaning-based marketing.” I hear H-P is looking for someone to run the operation. How about Werner Erhard or Deepak Chopra?"

They do need to get rid of all this gobbledy-gook and write plain English in their disclosures. There is no need to impress customers or tech analysts with how smart the company is. Both Deepak and Werner would certainly bring vision....and a lower share price.

After five years of debate, the Government Accounting Standards Board came up with revised disclosure rules that will have the effect of showing some state plans with lower funding ratios than before. Big deal! What's worse is that plan administrators know these new standards mean nothing.

The Wall Street Journal reports, "Many state pension managers downplay the impact of the new rules, arguing that the changes will merely affect how pension numbers are reported, and not the substance of the plans' conditions."

In doing a lot of reading on related issues, I believe it all boils down to one, overarching issue: Promises. State and local governments, abetted by unions, political machines, and special interests, have made promises to their employees which cannot be kept. It costs them nothing to make these promises, but these actors capture significant benefits. Moral hazard leads to unsustainable promises being made.

These promises made a Tammany Hall-like few bind all the citizens, the majority of whom, if presented with the data, would resoundingly reject the level and structure of public pension promises. "Shareholder activists" (whatever this means) are busy crying for corporate transparency about public company political contributions. There is absolutely no transparency and meaningful financial presentation of these liabilities in state, local and municipal reporting. So the people on the hook for these promises have no idea what's going on. How about transparency for a meaningful issue that affects every citizen?

State courts, populated by political appointees, keep reform of public pension commitments off limits by forbidding changes to employee compensation once the employee is working. Many plans also have explicit guarantees of the level of returns for plan assets. So, any changes to the system fall unfairly and inefficiently on new hires. The most concise exposition of these issues I've found is by hedge fund manager Kent Osband, author of "Pandora's Risk," in an article entitled "Fatted Leviathan." (his book is on my "Recommended" list on LinkedIn)

As Osband writes, the fattening of public pensions is a relatively recent phenomenon: "In inflation-adjusted terms, private benefits per working hour have risen by nearly a dollar since 2000. The corresponding state- and local-employee benefits have risen by nearly three dollars." If it's that recent, it can be rolled back.

Gaming of the system by municipal employees is rampant. A local political website in New York, where I was visiting, showed real data for a municipal employee in law enforcement whose total compensation skyrocketed in the years leading up to his retirement by overtime rising to several multiples of his base pay, which was also growing because of COLA. This made his retirement a lot more expensive to taxpayers, who will never know what went on. This kind of abuse is pervasive.

As municipalities in California, for example, have started to deal with their budget issues, they have done things like reduce their police forces by 25%. Law enforcement typically takes a lion's share of a municipal budget. The problem is that in a system driven by local property taxes, law enforcement and a safe community, collectively form the number one reason why property owners choose to live in a particular community, followed by schools. This short-term fix doesn't deal with the problem that the public pension promises can't be kept, nor should they be. Fix the compensation and benefit systems, align them to the market, and let taxpayers choose ,with the right information, how they want to spend their money.

Niall Ferguson in a recent Reith Lecture has resurrected and expanded on Edmund Burke's notion of generational compacts that ensure continuity and stability of democratic systems. He notes that our current public finances are going to place unprecedented burdens on young taxpayers, like your children and mine. Leaving aside what is "fair" and how we got here, there is a point that I take from Burke, recast by Ferguson.

Making these economically irrational and unwarranted promises to public employees and then making them irrevocable by judicial fiat puts future taxpayers down a rabbit hole. Future taxpayers have had no input into these choices. It is taxation without representation, which is tyranny. Those state court decisions need to be struck down, but my lawyer friends will protest. Without scaling back these outlandish, irrevocable promises and putting them into a rational, comparable economic framework, discussions about disclosure are like improving the the deck chair upholstery on the Titanic.

Friday, June 22, 2012

Today's New York Times has an article crying out for government intervention to expand the use of natural gas in automobiles. Of course, this will involve appointing another energy czar in the White House and sending billions tax dollars to favored special interests. Our focus should NOT be here, but in electric power generation. Why?

First, electric power generation is the biggest energy using sector in the US at 40 Quadrillion Btu in 2011, according to the Energy Information Administration. Transportation is the next biggest user at 27 Quad Btu. Increasing the efficiency of our national power grid, from generation through transportation and distribution benefits everybody, from every kind of business to state and local governments to individual households. Working on natural gas automobiles may benefit wealthy early adopters who don't need the subsidies and precious few others.

The business sector is already working on alternative fuel vehicles for trucks, vans and buses. They know what to do: let them figure it out, and a private infrastructure will probably arise to serve this changeover. Railroads are already relatively efficient in costs per ton mile, but they too are working on alternatives and will bear the costs of changing over, which will also be passed on to final users. There's little need to intervene here, as market signals are pretty clear and efficient. Taxes on things like diesel fuel, are not--just an aside.

We know that coal generated power plants are only about 35% efficient, but even integrated carbon capture plants, for all their huge costs and unknown technological risks, are only about 40% efficient. Natural gas is a better way to go, but we're not going to repeat ourselves here.

Transportation and distribution losses in the electric power generation sector amount to some 10 percent of generation. Swapping out to high voltage DC, and using better transformers and connectors can make a significant dent in capturing this low hanging fruit. We have huge global companies, as well as innovative smaller companies, with vast experience, competence and innovation in electricity transmission and distribution. Readers know who they are. They just need to be put to work on these issues.

By the way, the estimates of transportation and distribution losses don't include "congestion losses" which are borne by local power utilities, businesses and households as the utilities struggle to balance loads from peak demands with aging infrastructure and tools.

At the local household level, we know that smart grid technology, especially meters and insulation, can make a huge difference, but we also know that adoption on the consumer level is constrained by income and by a lack of awareness. There are worthy goals here and lots of savings to be had, but personal experience working on the consumer level tells me that this has to be driven at state levels down to the local levels. This is not fertile ground for Federal involvement.

Getting a smart power grid, per force more efficient, really improves our collective asset base and will allow everybody the potential to participate more freely in the burgeoning digital age.

Thursday, June 21, 2012

Nautilus Minerals's project to develop subsea massive sulphides in the territorial waters of Papua New Guinea has been put in jeopardy because of a dispute with the government of Papua New Guinea. According to a longstanding agreement, the PNG government chose to exercise an option on a 30% interest in the joint venture in exchange for covering a pro-rata share of the development costs. To its credit, Nautilus has even lined up a Chinese customer for the output of the project, and this delay has put in jeopardy the acquisition of the mining vessel required to move the project into development and production. After announcing the option exercise, the PNG government disputed some performance aspects of the work to-date, failed to pay its commitment, and has also failed to arrive at a negotiated settlement.

A comment I received suggested that this was an example of the risks associated with operating under the Law of the Sea Treaty. This is not a treaty risk because this project is clearly within PNG's territorial waters. The issue is clearly a conventional, commercial dispute. It seems that the PNG government wants to renegotiate its long standing deal, in a move typical of many emerging market governments. PNG's share of the development costs might amount to $47 million according to the company. It really doesn't help the climate for international investment to deal with corporate partners in this way, particularly those which have worked well right up to the option exercise date. The matter was discussed in a recent company conference call.

So, this isn't an example which might support the Rumsfeld argument for not entering into multinational treaty agreements. It's just business, which is complicated enough on its own.

Spain is in its second recession since 2009 with the highest unemployment rate in Europe. The world may find out later today that the condition of the Spanish banking system is worse than projected by the Spanish government. Against this background, Spain sold three year bonds at a yield of 5.457 percent. Why didn't the investors go on strike until after the banking results, when they would have information for pricing their bids?

I heard a comment that some of the big buyers of the issue were the Spanish banks themselves. The offering is described in the press as being oversubscribed. It just feels as if these interest rates and this kind of investor behavior border on the same irrationality shown at the peak leading up to the last global crisis.

I go back to Charles Prince's immortal quote: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”

Investors must believe that there is a meaningful liquidity backstop to this euro crisis. I don't think the backstop can be the ECB or any of the current European credit facilities with the funny acronyms. Surely investors won't be so foolish as to inject cash directly into the Spanish banks. Therefore, the bailout of the Spanish government must be assured, and so investors buy this deal.

Going back to a point I've made before: credit default swap spreads were a failed leading indicator of the last crisis. Applying the CDS to sovereign paper seems far worse than applying them to high quality corporate paper, where the spreads seem rational. Why should they be believed in the case of Spanish sovereign debt now? Academic researchers, e.g. Takeyama et al. from the University of Essex, have shown that interpreting the information contained in credit default spreads is problematic at best. I hope these investors get their risk-adjusted rate of return.

Tuesday, June 19, 2012

The First Pacific Advisors 2011 Annual Report, notes Morningstar's Fund Spy, has a dicussion of its taking a position in HPQ. It established a small position in the $40s when it believed that the P/E was 8. Further it believed that the printing business was an annuity (which is surprising) and that the services business would have adequate cash flows even in a down turn. "Subsequent research revealed that neither business was as resilient as we thought," which is why even in the world of mega-cap investing with overfollowed companies, there is always value in doing research and questioning your own assumptions. Once FPA had established a position, they allowed "rationalization" to creep into their process: in other words, it was difficult to accept that they had made a mistake, sell the stock and move on. I have often fallen prey to this emotion, especially if I had put a lot of work in on the front end.

HP management, FPA writes, made a series of reckless decisions, including a multi-billion dilutive acquisitions, a publicly announced commitment to WebOS which was retracted within a month, and declaring their intent to selling the PC business without a buyer and without regard to the impact on prospects and customers. This decision too was retracted, subsequent to the FPA report's being issued.

Their key conclusion is that Hewlett Packard is not Wang Laboratories, although its corporate evolution has quite a few eerie similarities. The stock declined to $21.50, and FPA added to positions on the way down, and they said the stock bounced back to $25.76 at year end.

In today's trading, Forbes reports that the shares traded below their trailing four quarter book value. The chart looks bad. FPA's talking about their own investment process and how it went wrong is very instructive for readers like me and for their own shareholders in understanding their valuation and investment process.

FPA was "wrong" on their investment thesis, but they acted as if their timing was wrong, and so they held on and added more. This is what they mean by rationalization. Are today's investors looking at a compelling valuation?

Watching Steve Ballmer announce Microsoft's launching of its own tablet computer made me think of classical musicians playing jazz or ethnic music. All the notes are as written, but the music is flat and boring. Mr. Ballmer's shirt looks like a bad parody of Apple execs looking naturally techy with with their shirt tails left outside their trousers. It didn't feel good.

Microsoft partners must have been cringing when they heard the announcement. Did they learn about it with the rest of us? Finally, I notice that the Surface will have a "kickstand." That word conjures up my first bike with pedal brakes and fat tires; the kickstand was something that bent, rusted and broke.

Monday, June 18, 2012

It's all over: there was a Greek election, as opposed to a return of the Colonels, which is good news. There will be a coalition, and that's better than anarchy. So really, nothing beyond the obvious has happened to assuage the markets, and certainly no positive surprise.

In the financial press, it is a discouraging sign that there are so many different Eurocrats speaking and opining about what to do next. As much as Mario Draghi, as President of the ECB, wants to be the Paul Volcker figure of the European crisis, he doesn't seem to have the political support in Bonn and Paris that he needs. White papers can be issued and ideas floated, but there is no Eurocrat financial leader who can really move this process forward. Perhaps most discouraging is the Spanish government's rather puerile insistence on accepting Euro assistance for its banking sector without any commitment to quick resolution of its problem banks.

On a different note, we wrote in May about Dodge and Cox Growth Fund reporting a Nokia position of 53.3 million shares at March 31, 2012, worth $292.5 million at the time. The stake is worth considerably less today. However, the financial press is abuzz about Microsoft stepping to buy Nokia: it seems that MSFT would have few reasons NOT to buy Nokia at this point.

Microsoft, as is its wont, is generationally late to the smart phone and tablet markets, and it has announced plans to develop its own tablet. They are generally not competent at developing consumer products, perhaps with the exception of XBox. However, Nokia really pioneered the modern cell phone, discounting the early ATT remodeling of the military satellite phone. Nokia phones were small, easy to use, had excellent battery life, good form factors and were durable. They should be able to develop the products for them, which is worth a LOT to MSFT shareholders.

The culture in Finland is very much of a Silicon Valley software company, and it's now headed by an ex-Microsoft exec. Plus the final decider: the vast patent portfolio would not be something MSFT would want to be picked off by Google or its Android partners. One presumes current discussions are about terms, timing and executive succession at Nokia. Sometimes value investors have to get bailed out to realize their value: nothing wrong with that.

Thursday, June 14, 2012

Donald Rumsfeld was Secretary of Defense from 1975-1977. I was working at the United Nations at the time, and my team was part of a much larger group working for the Third United Nations Conference on the Law of the Sea. My team was focused on technical issues in creating an economic regime for exploiting subsea mineral resources beyond national jurisdiction, what was to be called the "Area." At the time, the interest was on deep ocean manganese nodules, and there was a lot of excellent work being done by international research groups at Scripps Institution of Oceanography, CNEXO (Fr,) among many other research groups. I recruited an researcher from Scripps to build own my team's technical expertise. The promise of an orderly international legal and economic framework to develop these resources peacefully, was really an exhilarating prospect.

Our foreign policy regarding the economic regime for the deep seabed was handed over to a narrow cabal of corporate interests, led by executives from Kennecott Copper, which today is an operation within Rio Tinto. The rhetoric in all the speeches, official and unofficial communications talked about redistribution of wealth, socialism, paralyzing regulation, abdication of national sovereignty and so on. It's absolutely laughable to see this same language being resurrected today in a Wall Street Journal editorial from former Secretary Rumsfeld on June 13th. Reading this editorial, it's as if Secretary Rumsfeld has just emerged from a time capsule that he entered in 1977. Lots of things have changed since then, largely to the detriment of our strategic options in the future.

The rise of China as a global superpower with economic, military and strategic goals distinct from our own is something that was not on our policy radar at the time. We have written about China's claims in the South China Sea causing problems for some of our prospective partners and allies in the region. Much as we rightfully celebrated the fall of Communism, Russia sees itself as a global economic power with grand visions.. Russia has aggressively used the international vacuum on marine territorial issues to stake problematic claims in the Arctic Circle.

The U.S. military brass, as opposed to our politicians, have been paying attention. Admiral Samuel J. Locklear III, head of the U.S. Pacific Command told the Senate Foreign Relations Committee, "Competing claims in the maritime domain by some coastal states are becoming more numerous and contentious. Some of these claims, if left unchallenged, would put at risk our operational rights and freedoms in key areas of the Asia-Pacific,"

Our future budgetary realities, especially factoring in a health care time bomb in the wings, are dictating a smaller, more agile military, aided by a lot of technology like drones and robots. We're contemplating the next Afghanistan. Instead, what is going to be required in the Pacific and in the Arctic may be something quite different. Operations in these areas will be budget busters.

Failing to ratify the LOS treaty has left us without any avenue for internationalizing a discussion about maritime boundaries. China and Russia don't have any incentives to abide by any such international framework either. Our only option is to somehow project our military power over a huge, dispersed, and territorially complex theater that includes land, sea, the sea bed and ice. Our Navy will face shortages of both human capital, leadership and ships.

Even former Secretary Rumsfeld isn't blind enough not to acknowledge this reality, "The most persuasive argument for the treaty is the U.S. Navy's desire to shore up international navigation rights. It is true that the treaty might produce some benefits, clarifying some principles and perhaps making it easier to resolve certain disputes. But our Navy has done quite well without this treaty for the past 200 years, relying often on centuries-old, well-established customary international law to assert navigational rights. Ultimately, it is our naval power that protects international freedom of navigation. This treaty would not make a large enough additional contribution to counterbalance the problems it would create." I don't believe that our military leadership would agree with the former Defense Secretary's position. His cost-benefit analysis is also suspect.

There's no doubt that being involved in a truly global international treaty framework like the LOS will be messy, irritating, highly political and inefficient. Business as usual may be far worse. The bottom line is that we can't solve our future strategic geopolitical problems solely through a projection of our military power. To assume so would be irrational and naive. As the late President Reagan said, "Don't be afraid to see what you see."

Wednesday, June 13, 2012

My friend Larry McDonald, financial author and former head of the distressed asset trading desk at Lehman Brothers is on my must read list. I literally just opened his most recent reflection on the Euro crisis, approached from a different perspective but not dissimilar to my own conclusions. Here's a link to it.

Last week's glimmer of hope of a quick and orderly resolution of Spain's banking system using ECB assistance has faded away. The Spanish government should have been pleased with this tack, as it avoided the stigma of a "bailout" of the Spanish government. Instead, PM Rajoy is now dealing with his own political crisis, blaming his predecessors and suggesting that the EU use "all the instruments at its disposal" to counteract "volatility."

What's needed with Spanish banks, as with Irish banks in the past, is to take over management of the banks, write down assets to their market value, with the subsequent wiping out of shareholders and move to merge weak banks into healthier ones or to liquidate assets to pay debt holders. Now, the time frame has been moved back until auditors and consulting firms are finished with their various studies.

Meanwhile, the credit markets have spoken up and moved the Spanish sovereign 10 year bond rates to a euro era high of 6.72%, according to the Wall Street Journal.

French commentators and proxies are once again talking about banking union, fiscal union, and EU supervision of national banks. However, if leaders can't solve a simple problem like resolving a straightforward, single member traditional banking crisis in Spain, how could anyone have confidence in a system of multinational, international bank supervision by a bunch of bureaucrats who don't face popular elections?

It looks like we are right back where we've been for the past eighteen months with no "European" solution in sight. I went back to the Stern Lab Volatility Center to revisit some of the European bank systemic risk numbers. The Stern Lab uses a measure SRisk which measures for each bank the expected capital requirements at the onset of the next financial crisis, which is a market driven crisis, defined as stock market declines of 40% over six months. There's another interesting indication which is the SRisk%, the systemic risk of a given bank as as a percent of the total systemic risk in the global banking system.

Of the top ten European banks, Credit Agricole ranks number 4, despite the fact that the bank has the lowest market value of the top ten at $9.8 billion. Yet it's SRisk rank if number 4, driven primarily by its leverage ratio of 221.6, which is over twice the leverage ratio of the next highly levered bank in the ranking. Credit Argicole is reported in the Wall Street Journal as trying to shut down their Greek operations. Not surprising.

There is only one Spanish bank in the top ten risky European banks, and that is Banco Santander at number 10, with a market value of $17 billion. In the event of a crisis, it would have to raise capital in multiples of its market value, according to the Stern analysis. We know that this bank remains an institutional favorite because of its geographically diverse revenue stream, but it is still vulnerable to another global market crisis.

Globally, the Spanish banks don't appear high in the rankings, which supports the idea that the mortgage problems in their lending portfolios could have been solved through a normal resolution and workout process, much like the U.S. did during the S&L crisis and the failure of Continental Illinois. There's nothing to suggest that it would be otherwise, unless the books reveal fraud after the examination by outside auditors for Spain.

Gerald O'Dricoll formerly of the Dallas Fed makes a comment in the Wall Street Journal which supports this idea when he writes,"Many Spanish banks lent heavily to property developers and to individuals who wanted to purchase homes built by the developers. Spain's construction sector is substantially larger relative to the rest of its economy than is the construction sector in other euro-zone countries or the U.S. And bank debt to finance that sector grew much faster than elsewhere...Spanish banks have taken huge write downs on their loans, but not enough. Only the exact size of the future write downs is in doubt, not that they will be very large." Failing to fix the Spanish banking system quickly, as a demonstration of pan-European economic management, is a great opportunity lost.

French, German and British banks in the European top ten would have to raise capital in multiples of their market value in the event of another global crisis manifested as a stock market collapse. Credit Agricole seems to be a unique risk among the European top ten.

It's clear that even cleaning up Spanish banks won't end the crisis, as Italian fiscal policies and their opaque financial system would simply become the next in an unending series of problems. The European public and the politicians will eventually get issue fatigue as we roll into the fall of 2012, and the economies are already beginning to roll over. It may not be a pretty picture this Fall.

(I spent some time creating a spreadsheet with some data, only to find that if I don't use Google docs I cannot cut and paste to blogger from Excel and preserve the formatting. Therefore the need for this convoluted description, but the data are all to be seen on the site.)

Tuesday, June 12, 2012

Today's Star Tribune carried a story about Honeywell creating a business unit, cobbled out of existing units, to create Smart Grid offerings of products and services for both the electricity producer and consumer markets. It won't be an easy task for Honeywell.

We've written a while ago about GE entering this business through what could easily be called serendipity.
Because GE has some experience with direct to consumer businesses through appliances, they may have an edge over Honeywell. My limited experience with Honeywell's customer service in retail product support (furnace filters) has been very poor. Selling to the public and meeting their expectations is harder than making a corporate sale to a utility.

Again, I wonder why the Federal government isn't supporting the expansion and upgrading of our electricity grid, as opposed to funding losers in ventures like solar panels and Li-ion batteries.

Friday, June 8, 2012

I understand the need to respect patient privacy of personal medical information, and I would expect that hospitals and clinics would take normal IT business precautions to keep this information safe from inappropriate inside and outside access.

I was shocked to read a recent post on the blog of John Halamka, MD who is Chief Information Officer of Beth Israel Deaconess Medical Center, Chief Information Officer of the Harvard Medical School, and a practicing Emergency physician.

What is keeping him up at night? Here's what he said, "as a CIO, it's the mounting regulatory and compliance pressures that keep me up at night. They will require a level of resources and focus that will reshape my plans for the next year or more."

Specifically, here's what he has to implement over that period:
"An enhanced encryption program to ensure all personal laptops/tablets that access hospital systems are encrypted.

*An enhanced mobile/BYOD program that ensures all personal smart phones that access hospital systems are password protected, have timeouts, and encrypted as technology permits

*An enhanced learning management infrastructure so that every person in the BIDMC ecosystem can be held accountable for completing training requirements, including security and compliance topics. Creating this infrastructure requires a new level of identity management that captures roles and characteristics for employees, volunteers, board members, and contract workers.

*Enhanced Conflict of Interest reporting including the management tools needed to followup on any disclosed conflicts

*A comprehensive audit of our security program and polices - where are we "standard practice" and where are we "best practice".

There's no doubt that hospitals, clinics and health care providers never had their databases "hermetically sealed," particularly in the old days when everything was in those awful manila folders flopping around shelves. No problem, that's why we have IT. Instead, when you go to visit a clinic for routine medical care, you're told where to stand so that you don't see your neighbor's confidential information or overhear her conversation with the receptionist. You sign a boilerplate form about the clinic's privacy policy, which nobody reads. You typically receive on an annual basis a boilerplate report on the clinic's policy and sign off that you have read it. Do a Google search for "HIPAA compliance" and look at the endless list of IT software, systems and consultants who can help drain money away from care into their pockets.

Does any of this improve the clinical quality or efficiency of our health care? I think not. Dr. Halamka's FY 2013 IT budget, he says, will devote over one third (!) of its dollars to security and compliance projects. Remember that this is not for bringing clinics in Appalachia up to speed. That level of spend is for parts of the Harvard health system. I think they know how to respect patient privacy of information without being told by Federal and state governments.

In 2003, medical practitioners writing in peer reviewed journals warned about the added costs for imperceptible benefits. Since the Federal act merely put a floor on compliance standards, after individual states added their own webs of regulation, we've arrived at the situation that Dr. Hamalka faces.

Wednesday, June 6, 2012

My friend Ward McCarthy sent me a Reuters note saying that Germany, through several political channels, has expressed the notion of a way for Europe to address a Spanish banking crisis without requiring an ignominious bailout of the Spanish government. This is a refreshing sentiment. We've said before that there seems to be nothing special about the nature of the Spanish banking crisis. It seems to have some parallels with our own S&L crisis of years back. The U.S. bank resolution process had to work overtime in high gear, but everything got done.

Providing multilateral aid/financing to support a bank resolution in Spain sounds like a potential way forward. It does suggest backing off the position that no European funds would be provided for a direct recapitalization of Spanish banks. And, it would seem reasonable that there should be some European participation in the resolution process, although this might be anathema to Iberian pride.

Let's see how things develop from here, but this sounds like it could be good news.

Tuesday, June 5, 2012

We wrote several years ago about this Federal Reserve Chair politicizing the Fed and putting it at the electoral service of two administrations. We have heard about Bernanke "learning" from the inaction of Japanese monetary authorities during their crisis, resulting in their long comatose economy. Well, this Fed has taken the approach of always doing something, viz. QE, QE2, Operation Twist, perhaps Operation Twist and Shout. Doing too much and giving too much of the wrong policy medicine is just as foolish as doing less, perhaps more so. It really needs to stop, as several of the more sensible Fed Presidents like Fisher and Kocherlakota have been saying for two years.

I found an interesting paper by Pietro Catte et al. of Banca d'Italia contained in a book called "Monetary Policy After the Crisis," published by The European Money and Finance Forum. The reason I start here is that it examines the question of what might have happened had the Fed not pursued its secular low interest policy in the long run up to the financial crisis. For those macroeconomic model geeks out there, the model used is a variant of the one the IMF has used for policy simulations, and it has credibility as well as some obvious limitations. However, quibbling about model specification doesn't, I believe, change the basic conclusion of Catte's paper.

The authors simulate a different U.S. monetary policy from 2003Q1 to 2005Q2, which is a fulcrum for the 2002-2007 run up to the global crisis. The Fed during this period increases the target Fed Funds rate from 1.5% to 3.75% in 2005Q2, maintained at that level for two quarters, following a Taylor Rule thereafter.The overall interest rate path follows a Taylor Rule policy guideline. At the same time China does not pursue its mercantilist policy, but rather stimulates domestic demand and lets the renmimbi appreciate significantly. Japan and Germany, in Catte's "counterfactual" simulation, also stimulate domestic consumption. The simulation is really a global demand rebalancing, something which Paul De Grauwe is currently advocating within the European Union.

The global demand shock ticks up the inflation rate in the short term. Long-term bond premia increase. In the U.S. the simulation posits increases in U.S. mortgage rates. The choice of the interest rate path in the model is chosen to put 2002-2007 rates at their 1990's average levels. In the simulation, at year-end 2006, U.S. home prices in real terms are 8% lower than baseline. The overall inrease in home prices from 2001-2006Q4 is cut by 11% in the counterfactual simulation.

Since the simulation doesn't contain a discrete banking sector model, the authors have to assume that U.S. policy makers didn't explicity allow or encourage lax underwriting standards or give up on supervision of banks and thrifts, as they did with IndyMac.

The punch line of this simulation? The loss in U.S. GDP from the peak to the cycle trough is 3% of GDP versus an actual 6% of GDP. A pretty significant difference! Continuing the current low interest rate environment through another QE does nothing to address the persistent imbalances among national output, consumption and export levels.

Monetary policy is absolutely the wrong tool to manage macroeconomic imbalances, more properly the realm of fiscal policy. Forcing a rigid fiscal austerity on the weak sisters in the European periphery while the stronger countries stand holding their breath with arms folded, is not the right answer.

First things first. No QE3. No Operation Twist and Shout. No more monetary "Shock and Awe." Lowering rates further or keeping them low indefinitely will NOT raise the "animal spirits" of entrepreneurs and megacap corporate CEOs. Why? If there's no reasonable prospect for increased final demand in the foreseeable future, businesses will sit on their cash because the capacity increasing projects still won't be worthwhile even if rates decline by a further 30 bp. They will instead pursue mega mergers and short-term measures to raise their share prices. Larry Summers makes this point in more colorful language than I can conjure up.

Fiscal policy should be aimed at nudging, cajoling, and jawboning industry to build more piplines to move North America's inreasing energy resources to where consumers need products, building LNG terminals for export, building more refineries, swtiching coal plants to gas, and building out the power grid and telecom infrastructure, to name a few. We have to get rid of the budget-busting social initiatives currently in place in order to accomodate a change in the expenditure mix.

Investing in what we need to become productive in the future would be a desirable by-product of this persistent low-rate environment. Its blind perpetuation would be a continuing transfer of wealth to financiers and speculators.

Monday, June 4, 2012

An interesting 2011 paper from Andrew Ang of Columbia Business School and Francis Longstaff of UCLA Anderson Business School, develops useful findings which apply to current discussions about sovereign risk.

The authors take the U.S. and the ten largest states (CA, TX, NY...) and compare them to the Eurozone countries, using CDS spreads as a measure of changes in sovereign risk. Their goal is to get a feel for how much of sovereign risk is truly systemic. An underlying principle of the statements of most international public officials is that global systemic risk is the bugaboo behind real risks to the system. Ang and Longstaff use CDS spreads as their market-based measure for pricing risks and changes in risk. They then partition the overall risk into systemic risk and idiosyncratic risk.

In the U.S., they find that California as a sovereign issuer has 5x the average risks of the other 9 U.S. states in the sample. New York, by contrast, has surprisingly almost no systemic risk: risk associated with its securities are almost all idiosyncratic. So, New York's securities could be held in a diversified portfolio of U.S. sovereign securities, reducing the portfolio risk. Applying the same reasoning to California paper wouldn't yield the same risk-lowering benefit.

For all ten of the largest U.S. states in the sample, the average systematic risk percentage is only 12.2%. California's systematic risk percentage is 36.8%, certainly well above average. However, in somewhat of a counter intuitive conclusion, systemic risk for U.S. state issuers is significantly lower than idiosyncratic risk specific to the issuer in question.

Europe by contrast shows results which suggest that the nature of sovereign systemic risk is quite different between Europe and America. The average systemic risk percentage for all Eurozone nations is 30.9%, 2.5x higher than the average for American issuers. The country with the highest proportion of systemic risk in total risk is France at 53.2%.

Even as macroeconomic discussions today focus on the relatively small size of the Greek economy in the Eurozone, the authors find that the Greek systemic risk component is 3x that of Portugal, Spain and Belgium, the other weak sisters in the Eurozone. All of them, however, carry much more systemic risk than does German paper.

What factors best explain changes in systemic risk? What might constitute a transmission mechanism? Changes in VIX and variations in overall equity market returns are the major factors explaining systemic risk in the EU and in American sovereign issuers.

Think about the findings here and ask yourself again, "Why would Germany be sanguine about moving towards fiscal union?"

Friday, June 1, 2012

The Wall Street Journal has a video interview with Morgan Stanley fund manager Ruchir Sharma who makes a number of comments about emerging markets that relate to our recent post on those markets, and on India in particular. Sharma notes that emerging markets are 40% of the global economy. More relevant than that number is the fact that according to Morgan Stanley Capital International's Emerging Market Index, they only comprised 14% of global equity markets in 2010.

Sharma suggests that after a hot decade, emerging markets have become a "mature asset class." If that's true, then at 14% of global equity capitalization, there isn't a large playground for active fund managers to add value. Equity investors became excited about India when economic growth accelerated from 5-6% before 2003 to 8-9% after that, driven by a first wave of economic reforms and liberalization towards foreign investment. Unfortunately, as we've written, the economic reform wave has washed ashore and now government pronouncements express ambivalence and antipathy towards foreign investors.

Sharma suggests that emerging markets may be like "shooting stars" rather than suitable homes for long-run equity investors, who require liquidity, stable tax policy, and a clear regulatory framework in order to comfortably capture any excess returns, which Sharma suggests may not be forthcoming in the future. One website paraphrases Sharma as saying that India has lost the plot on economic growth. This is very much in line with our recent post.

Dimensional Fund Advisors Value I (DFEVX) fund is the largest emerging markets mutual fund, according to Morningstar data presented in the New York Times, at $16 billion in assets, held in 2,235 positions with an expense ratio of 0.61%. This seems like a potentially attractive way for an individual investor to participate in the emerging markets, but DFA funds are available only to investors who sign up with a dedicated DFA advisor. Other emerging markets funds have expense ratios up to 1.25% which is too much to pay.